What are Exchange Traded Funds
Exchange Traded Fund (ETF) is an instrument which invests in the basket of securities that, replicates the composition of a market index, like Nifty, Sensex, Bank Nifty or CNX – 100etc. Unlike diversified equity mutual funds, ETFs do not aim to beat the benchmark index; the objective of ETFs is simply to reduce the tracking error versus the Index it is tracking.
Since ETFs are listed mutual funds, it can be bought and sold only on stock exchanges, therefore, investors must have demat and trading accounts to invest in ETFs.Being listed funds, ETFs are priced on a continuous real time basis like stocks whereas the Net Asset Values (NAVs) of mutual funds are priced at the end of the day.
There are advantages and disadvantages of investing in ETFs versus diversified equity funds. The main disadvantage is that, diversified equity funds can give higher returns than ETFs as the diversified equity fund managers aim to beat the index, while ETFs track the index it is benchmarked to.
Fund managers can beat the index returns through alpha or beta or both. Alpha is the extra risk adjusted returns which can be generated by the fund manager of an actively managed fund. While Alpha is the biggest advantage of an actively managed fund like diversified equity funds, there is no alpha in ETFs.
Some fund managers deliver higher returns by taking more risks, or in technical lingo, beta. Beta in simple terms is the risk taken by the fund managers relative to the index. The fund manager will get higher beta, by investing more in index constituents like stocks and sectors that rise faster than the index. However, index constituents which rise faster than the index in rising markets, also fall faster than the index in falling markets.
Therefore, from a risk perspective therefore, ETFs are subject to purely market risks, while diversified equity funds have stock and sector risks because the fund can be overweight or underweight on some stocks or sectors, relative to the index. Read what are diversified equity mutual funds
ETFs are very much like mutual funds. ETFs offer capital appreciation and risk diversification like any other mutual funds. The biggest benefit of investing in ETFs with respect to diversified equity mutual funds is cost. The effort required to manage an ETF is considerably less than a diversified equity mutual fund because the fund manager is simply looking to replicate the index. Hence the expense ratios of ETFs are considerably lower than diversified equity mutual funds. Therefore, over a long investment horizon, 1%-2% of lower expenses can have a significant impact on returns through compounding.
As our market becomes more mature and efficient, opportunities to exploit pricing inefficiencies will become more and more limited. So far pricing inefficiencies have enabled the fund managers to capture valuation upsides and as these opportunities get limited, the ability to deliver extra-ordinary alphas will also get restricted. Expense ratios will then become an increasingly important factor in mutual fund investment returns. In fact, in mature markets like the US, financial advisors insist their clients to allocate more money to ETFs.
Therefore, we can conclude that ETFs are good investment options for investors who are looking for market returns at a low cost.
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